The Crisis & Economics, Part 3: Econoracles

This is part 3 in my series on why and how the 2008 financial crisis is relevant to economics. The first instalment discussed why the good times during the boom are no excuse for the bad times during the bust. The second instalment discussed use of the Efficient Markets Hypothesis (EMH) to defend economists’ inability to forecast the movements of financial markets. This instalment discusses the more general proposition that crises are events whose prediction is outside the grasp of anyone, including economists.

This argumentinitiallysounds quite persuasive: the economy is complex, and the future inherently unknowable, so we shouldn’t expect economists to predict the future any better than we’d expect from other analysts of complex systems. However, the argument is actually a straw man of what critics mean when they say economists didn’t foresee the recent crisis. It confuses conditional predictions of the form “if you don’t do something about x, y might happen” with oracle-esque predictions of the form “y is going to happen on December 2003”. Nobody should have expected the details of crisis – many of which were hidden – to be foreseen, and much less a prediction about exactly which banks would fail and when. Instead, what is expected is for economists to have the key indicators right and know how to deal with them, to be alert to the possibility of crisis at all times – even in seemingly tranquil periods – and to have measures in place to cushion the blow should a crisis occur.

In fact, those who study earthquakes or hurricanes do ‘predict’ them in the above sense: they understand where they’re most likely to occur (for example near fault lines), and at roughly which frequency, time and magnitude. They also have an idea of how best to combat them: areas which are prone to earthquakes and hurricanes – funding permitting – have dwellings built in such a way that they can withstand such occurrences. They understand why disasters happen, and their models tell us why they cannot be predicted. For example, it is common knowledge that weather forecasts get less accurate the further away they are due to the sensitivity of the model to initial conditions, a point based on complex mathematics but communicated well by meteorologists (not to mention that weather forecasts are improving all the time).

While there’s been a lot of kerfuffle over exactly who ‘predicted’ the crisis and what that means, the most important point is that those who did warn of a crisis like the one we’re going through identified key mechanisms (debt build up, asset price bubbles, global imbalances) and argued that, unless these processes were combated, we’d be in danger. I appreciate that the ‘stopped clock’ problem really is a problem: there are so many people predicting crises that eventually, one of them will seem to be right. However, this is easily countered by using the same framework to make predictions outside the crisis (predictions in the general sense of the word, not just about the future). For example, Peter Schiff predicted a financial crisis quite a lot like the one we’ve been through, but he also predicted hyperinflation, suggesting that his model is wrong in some way. Conversely, endogenous money models are consistent with both the financial crisis and the subsequent weak effects of monetary stimulus: since money is created as debt, private debt can have major effects on the economy, and since banks do not lend based on reserves, there’s no reason for an increased monetary base do produce inflation.

Finally, while natural disasters are almost entirely exogenous phenomena, the economy is a social system, so we have a degree of control over it, both individually and collectively. It’s perhaps a testament to how the neoclassical approach naturalises the economic system that some economists feel recessions can be compared to natural disasters (not that this would mean they had no responsibility for alleviating their effects). Since economic models are frequently used to inform government policy, it’s quite clear that economists appreciate this point; however, since they often admit they don’t really understand what causes recessions, they are doing the equivalent of sending us up in toy planes. It’s fair to say that you don’t fully understand the economy; it’s quite another thing to say this, then recommend ways to manage it. But the relationship between economists and policy is a matter for the next part of the series.

The comment about Professor Douglas V. Orr (City College of San Francisco) is very inspirational, too.

Let me just make two observations.

The first one is based on Peter Backus’ open letter and I apologize if I sound like a broken record on this, but it provides a good launching pad: I think we really need to define what it means “to predict” something in economics.

First Backus asks “What do we mean by ‘predict’?” (You can see Noah Smith’s influence in the text, btw.)

Next paragraph Backus mentions people who gave evidence of a measure of foresight, even quite considerable and accurate, to say in the same breath: “But this is NOT prediction”.

My question is: why is that “NOT prediction”? At no point Backus explains, but the impression I get (which I also got from Smith’s post) is that, probably quite unconsciously, he raises the demands on a successful prediction beyond what’s reasonable.

So, if one predicted, say, that the housing bubble was about to burst, then the objection is “ah, but you didn’t predict the year”; if another one says “wait a minute, I did predict the year”, then the objection is, “big deal, but you didn’t predict the month, and how much the prices would fall”. You get the idea.

Perhaps there should be some kind of acceptance threshold.

The second observation refers to a detail I observed here (but it’s very common, so you are not the only person involved): prediction does not need to be limited to predicting crisis, just like weather forecasts are not limited to predicting storms.

Backus’ letter is full of doublespeak and confusion, so it’s a bit of an easy target. I don’t see how knowing the economy was heading into a recession in fall 2008 is any sort of accolade, considering it was bloody obvious.

Anyway, my preferred criterion for prediction is identifying mechanisms/processes correctly. If somebody says that a crisis will happen a certain way, and then it does, I’m not too bothered about whether their predictions are out by a couple of years. Predictions should also be conditional: if something major changes, such as policy, then your previous prediction might not hold.

However, there’s no escaping that it’s ultimately a judgment call whether or not a framework should be retained. If someone’s model is underestimating how long the system will hold out, it might need some tweaks. If they are really far out, it might need more drastic changes. The important point is that timing is less important than mechanisms, but Backus and others like him ignore this completely and attack the ‘oracle’ straw man.

What I mean is that the threshold of acceptance should be reasonable (a bit like in Dirk Bezemer’s paper).

And, I also think that there should be a definite threshold so as to avoid the criticism Steve Keen has received: “Oh well, you claim to have predicted the housing bubble collapse, and you provide this evidence… Let me see… Ah! There! You never mentioned anything [for instance] about the Lehman Brothers’ bankruptcy. Therefore you didn’t predict anything”.

To put it another way: to avoid moving the goal posts **after** the goal was claimed (which is what I feel it has been done to Steve Keen)

Ultimately, I don’t think there’s too much disagreement here over prediction. What we are dealing with is not a problem with how we define ‘prediction’, but hegemony. These tactics will always be used to dismiss outside critics while neoclassical economics is dominant; if it ever isn’t, they will quickly seem absurd to all.